Bond ETF Investing: What to Consider When Selecting a Fund

Text on screen: John Nersesian, HEAD OF ADVISOR EDUCATION

Nersesian: Hi everybody, I'm John Nersesian, head of Advisor Education at PIMCO. Thank you for joining us for our conversation today around the concept of ETF fixed income investing.

I'm so pleased to be joined by my colleague Dave Braun. Dave is a managing director and a fixed income portfolio manager for PIMCO. Welcome Dave.

Braun: Thank you for having me. 

Nersesian: So, Dave, let's start at the top. Tell us what are the structural advantages or opportunities of using an ETF to gain access to fixed income.

Braun: The bond market is relatively inefficient, you know, relatively high transaction costs.

Text on screen: David L. Braun, PORTFOLIO MANAGER

So, a well-diversified high quality ETF, is a way to get diversified access to the bond market with minimal transaction costs. And the ETF vehicle itself daily, daily trading. Intraday trading, daily transparency. Just a way for investors to get access to an one ticket at one share class fee exposure to a broad basket of securities.

And behind the scenes there are market makers and authorized participants ready and willing to create at NAV pricing. When there's a big inflow into a fund or an outflow into a fund. So, you know, any good active management ETF shop has a capital markets desk that can help the advisors out there and their investors gain access to the fund.

Nersesian: Tell us a little bit about the advantage of using an active approach in that space.

Braun: Yeah. So you're opening the can of worms of the big debate about active versus passive. Right. And when you look at… Let's look at equity funds first, there are data and most folks in the industry's data shows that the active managers do have a tough time beating their passive peers.

Text on screen: FULL PAGE GRAPHIC: TITLE – Percentage of active funds within each category that outperformed their benchmark (10-year). The bar chart shows the Morningstar Fixed Income categories in the blue bars and the Morningstar equity categories in the green bars. The blue bars on the left shows four fixed income categories outperforming their benchmarks, with 80% of Intermediate Core and Core Plus funds outperforming, 83% of Short-Term Bond funds outperforming, 78% of Ultrashort Bond funds outperforming, and 39% of High Yield Bond Funds outperforming. A yellow line running across the four blue bars represents the average outperformance across the bond categories, at around 79%. The green bars on the right show equity categories, with 18% of Large Blend funds outperforming their benchmarks, 24% of Large Growth outperforming, 42% of Large Value outperforming, 56% of Foreign Large Blend outperforming, and 53% of Diversified Emerging Markets outperforming. A yellow line that runs across the five green bars represents the average outperformance across equity categories, at around 43%.

Only about 30% of them, you know, successfully beat the passive peer. 

Braun: And everyone just knee-jerk thought, oh, that must be true for bonds too. On our website, you go see our research, we believe bonds are different. The active managers have historically had success being the passive peer groups. So, the tune of about 80% of core and core plus actively managed funds have beaten their passive peer groups over the last decade. So, the data's different. Now, we would also argue it's a challenge to replicate the Agg in and of itself.

Nersesian: Okay. Why is that?

Braun: Yeah. Well, one, unlike the S&P 500, 500 means 500 securities. The Agg has over 13,000 securities in it.

Text on screen: FULL PAGE GRAPHIC: TITLE – Index structure radically different than equities.The chart on the left shows a blue bar with 13, 617, which are the number of holdings within the Bloomberg U.S. Aggregate Bond Index. The blue bar on the right shows 503, which are holdings within the S&P 500 Index. The table on the top right shows the standardization, life, new issuance, and trading characteristics of stocks and bonds. The differences between stocks and bonds are as follows: Standardization for stocks is high and various for bonds; Life for stocks is perpetual and finite for bonds; new issuance is infrequent for stocks and frequent for bonds; and trading is done on exchanges for stocks and over the counter for bonds.

So, it's more complicated. The S&P 500 has minimal turnover every year as a few names drop outta the S&P 500 few names come in. The Barclays Agg has over 25% turnover a year. So, you're chasing a more complicated index trying to replicate it and with varying degrees of success.

And then a couple of reasons why we think active work in the bond market, but not in the equity market. The equity market's very efficient exchange traded whereas the bond market is less efficient and more opaque. It's over the counter traded and a large active manager like PIMCO can garner both an information and an execution edge to deliver alpha versus someone just trying to replicate the index. Another thing to think about is how's the index constructed? If you think about the Bloomberg US Aggregate, It's debt weighted. So you're by definition buying the bonds of people who are borrowing more and more, who are more indebted.

Nersesian: They construct the index based on the largest borrowers. Who by definition are more indebted and therefore maybe have a lower credit quality.

Braun: Yeah. So I, I always joke that if you and I open up Dave and John's bank. And our underwriting manual where we decided to give out loans was solely based on how much existing debt you have. outstanding. If they had a lot outstanding, we'd give them a loan. If they had no debt or very little debt, we might not give them a loan or we give them a very small loan. It's kind of the opposite of how you would want to actually lend money, right? So, that's what you're doing, you buy the index.

Another interesting thing is what's good for the issuers of the debt might not be good for the buyers of the bonds. Well, you and I were talking about this earlier. If you look at the Barclays Aggregate or the US Aggregate, 15 years ago, it was two years shorter than it's today.

Why, why is it longer now? Well, issuers whose bonds are going in the index are smart. We were at once in a generation low end rates, they issued more debt out the curve. So, that extended the index. If you're a passive replicator, you're along for the ride. The US Treasury, the treasuries in there, the US households and their mortgages and corporates, and the corporates in there all said, I'm gonna extend my maturity profile. And you went along for the ride. You rented them more and more out of the curve at all-time lows and rates.

Nersesian: How many investors do you think really know that the investor who chooses a passive approach to fixed income buys the Agg doesn't necessarily realize that the characteristics of what they own have changed materially and may not necessarily meet their objectives?

Nersesian: So, there are advantages, liquidity, transparency, diversification, professional management, they all sound pretty compelling. Now, there are some characteristics that we often use as investment consultants to really measure, if you will, the effectiveness, the skill of that manager. We look at things like tracking error, we look at things like information ratio. We look at things like active shares. Do you want to speak to some of those characteristics specifically?

Braun: Yeah. So we believe that, you know, that rather than looking at how you measure a passive manager, it's gonna all be, you know, fees and tracking error to the index. How tight are they matching it?

Nersesian: Those are the only two things we look at for a passive manager.

Braun: People care about. We think in active, you've got to expand what you look at. You obviously got to look at their alpha both before and net a fee. The alpha, they're generating above and beyond that passive index. But then we are, we would argue that number's, not the end all be all, you need to dig deeper. How are they getting that alpha? Right? And as you alluded to with information ratios and sharp ratios, what is the risk adjusted return they're getting on the volatility they're taking? So, a metric like that is a good way to look at it. We also believe people should study the manager's consistency of alpha. Is their alpha flailing around very high, very low from year to year? Or is it more steady in grinding it out?

Nersesian: Right.

Braun: Another thing is how do they perform over different parts of the business cycle? This is a key one. There are a lot of credit heavy core and core plus managers out there who put so much credit risk into a core bond fund. Works really well during the expansionary part of the economic cycle when stocks are going up, that credit's doing well. But then as soon as you hit a slowdown in the economy, stocks fall, that credit risk they put in the portfolio starts behaving like equity risk. And that's exactly when you want your bond fund to be that ballast in your portfolio.

Nersesian: So, you've got that flexibility. If you feel we're at a different part of the economic cycle, you can amp up or amp down.

Braun: And right now, given valuations and where we are in the cycle, we have taken credit risk down.

Nersesian: I like your approach to this, Dave. It's not just, am I getting an excess return? The question is, how am I getting it?

Braun: And is it sustainable and durable?

Nersesian: Is it gonna be persistent for me? Am I setting myself up for future under performance?

Braun: Exactly.

Nersesian: I love those comments. Well, Dave, I want to thank you for spending some time with us today. Very helpful, very educational, and I want  to thank our audience for spending some time with us as well. If you'd like to learn more about this or other PIMCO strategies, we encourage you to visit us@PIMCO.com or to contact your PIMCO account manager.